Index linked gilt

nonolerigolo

There are numerous discussions about gilt and index linked but, I am still unsure about index linked gilts.

I am fully aware of conventional gilts.
if I was to buy an index linked gilt today at £100, would it mean that I would get £100 at maturity therefore I would not lost any of the capital? This is the part  that is important to me, not losing the capital. 

 In addition I will have an increase based on RPI or CPI depending on bond maturity. What date does RPI change to CPI. 

I do not quite understand how index linked gilt can be bought today at £100 which are not new and would have in some way already inbuilt inflation so in theory worth more. I do not know how to calculate what they would be worth in theory today

Is there a good book about index linked gilt? Thank you 

GeoffTF

This is the official source:

https://www.dmo.gov.uk/data/gilt-market/index-linked-gilts/

Most of these questions were addressed in a recent thread.

JohnWinder

‘if I was to buy an index linked gilt today at £100, would it mean that I would get £100 at maturity therefore I would not lost any of the capital?’

Your question is ambiguous; are you ‘paying £100 today’ or is the inflation adjusted value £100 today? Don’t reply, we can deal with both.

The linkers are issued with a face value of £100. Each few months, when the Treasury announces the updated RPI, the face value is adjusted. Since we rarely get deflation, the face value usually goes up. That process continues until maturity, at which time the holder is paid the adjusted face value. In some countries, however bad the deflation is, the adjusted face value never is allowed to fall below £100. You could research what UK Treasury does.

That’s all about the face value. The price you pay to buy the linker, and the price you get if you sell the linker before it matures, is almost always different from the adjusted face value but those prices will get closer and closer together as any bond gets closer to maturity. That’s because everyone knows in the last few days/week/months what the redemption value will be, so why would anyone pay more to buy the bond in the last few weeks/months if there’s no more coupons to be paid?

If the linker was issued with a coupon of 1%, and sometime later interest rates fall, that bond is now more valuable because it’s paying a higher coupon than you can now buy, so the 1% bond’s price will rise. It’s face value won’t change, unless the RPI changes, and that change is not dependent on interest rate changes. 

Does that answer your question?

I don’t know about CPI and RPI changing.

‘I do not quite understand how index linked gilt can be bought today at £100 which are not new and would have in some way already inbuilt inflation so in theory worth more. I do not know how to calculate what they would be worth in theory today’

Here’s how with very artificial figures. A 5 year linker issued one year ago has a coupon of 5%/year. Inflation has increased its face value to £102. Suddenly now, interest rates for linkers maturing in four years rise to 6%/year, thus forcing down the price of your linker to £100. Remember, a 1% rise in interest rate will push down the price by 1 times the bond duration which is about 2 years in this case. So the price falls to £100, but the adjusted face value remains at £102.

There are very complicated formulae for calculating bond prices; let us know if you can’t find them. Or take the easy route. Plenty of people in the market are calculating what bonds are worth, and setting the prices accordingly. 

cwep2

The principal (ie the £100 at maturity) is adjusted based on cumulative RPI for the bond's lifetime.

Broadly speaking if you invested £100 now then if RPI was positive you would get paid back more at the end. You get coupons as well. But a bond issued a few years ago might have notional amount of £100 but you buy it now for £120, you'd still get more back if RPI was positive, but of course negative inflation (whilst rare, it is not impossible) would reduce this notional payout. The same would be true if you bought it at issue date for £100 and we had negative RPI for the lifetime of the bond, you would get less than £100 back at maturity. 

The general (economic) theory is that if the 'market' is pricing inflation correctly then there should be no difference buying a linker vs a normal Gilt, but if you think inflation will be higher than the 'market' expects the linker will earn more and vice versa. All of these securities have a price set by supply and demand so in theory if one was way cheaper because it didn't factor in inflation then everyone would buy it and the price would adjust until it's kind of close to 'fair value'. 

GeoffTF

JohnWinder said:
The linkers are issued with a face value of £100. Each few months, when the Treasury announces the updated RPI, the face value is adjusted.

I don’t know about CPI and RPI changing.

Linkers are not always issued with a face value of £100. The face value of old style linkers used to be adjusted in line with the RPI. New style linkers are more complicated, with clean price that is not inflation adjusted and a dirty price that is.

https://ehs.org.uk/index-linked-gilts-and-the-end-of-rpi/

JohnWinder

Thanks. Some detail there I wasn’t aware of. But I still think linkers might be issued with a face value of £100, in the sense that they have ‘£100’ printed on the face or if they don’t then all subsequent calculations assume they did. Yeh, or neh?
If I’ve got it right, this time, the (post 1995 'new linkers') price of the first sale (from the Treasury to the first owner) will have as its starting point £100, and then the price for this first buyer will be adjusted in line with the daily inflation rate as it occurred from about 3 months before bond issuance to about 3 months before the first coupon.  https://www.dmo.gov.uk/media/jgtoofwc/indexlinked3m.pdf.  There must, I think ‘must’, also be an adjustment to reflect any difference between the current interest rate for bonds like that one, and the coupon value specified on the bond. If the bond promises to pay a 1% coupon, but the interest rate obtainable on existing bonds of that duration is 2%, no one is going to pay the £100 adjusted for several months of inflation as they’d lose out on 1% of interest every year without any compensation.
There’s potential for confusion in the way linker prices are listed as ‘clean’ and ‘dirty’, ie without inflation adjustment and with adjustment. It seems they are ‘traded’ at clean prices, but settled at dirty prices. In common parlance ‘trading’ would mean buy and selling, so that a traded price would be the price you pay. Not so with linkers as you pay the settled price. It's putting me off linkers!

‘But a bond issued a few years ago might have notional amount of £100 but you buy it now for £120, you'd still get more back if RPI was positive, but of course negative inflation (whilst rare, it is not impossible) would reduce this notional payout.’

There’s room for ambiguity there. What does ‘notional amount’ mean? You’d ‘still get more back if RPI was positive’ could mean return of principal or total return. As an example, if you pay £120 to buy, but inflation takes the adjusted face value to £110 at maturity, you’ll lose £10 of principal. N’est pas?

GeoffTF

It is simpler to consider the case of conventional gilts. In principle, the DMO could launch a gilt issue with exactly the right coupon to give a market value that equals the redemption value. In practice, it cannot do that. What happens in practice is that the DMO decides on the coupon, maturity date and size of the issue. It then auctions the gilts for the best price it can get. If the coupon is small (there are recent issues with coupons of 0.125%) the gilts will currently sell for much less than their maturity value, with the low interest being compensated by a capital gain that is free of UK taxes. These issues are attractive for higher rate tax payers, who will pay a good price for them. Gilts with high coupons give a "tax free" capital loss. That is not attractive for tax payers. These issues are still attractive to those who pay no tax. but there is less demand for them overall, so they sell at less favourable prices (i.e. they have higher redemption yields).

Index linking adds a further layer of complexity, but the issue process is the same in principle.

nonolerigolo

Thank you everyone for the information